Hedging Policy Research Articles

Signaling Incentives and Derivatives-Based Hedging

We model a commodity producing firm with private information about future volume and whose low realized cash flows cause it costly financial distress. A firm's first-best strategy is to sell forward all future production, avoiding any price risk. Low-volume firms, however, have an incentive to mimic, which in equilibrium distorts the hedging strategy of high-volume firms. Under certain conditions, high-types hedge more than their own production volume in equilibrium. Alternatively, equilibrium sometimes entails that high-types hedge less than low-types. When allowing firms to use multiple types of derivatives, we show that high-types use both options and forwards, while low-types only use forwards. The model suggests that heterogeneous and prima facie inefficient hedging policies may be due to signaling and not speculation or risk shifting.

Extraction and Preference Ordering of Multireservoir Water Supply Rules in Dry Years

This paper presents a new methodology of combined use of the nondominated sorting genetic algorithm II (NSGA-II) and the approach of successive elimination of alternatives based on order and degree of efficiency (SEABODE) in identifying the most preferred multireservoir water supply rules in dry years. First, the suggested operation rules consists of a two-point type time-varying hedging policy for a single reservoir and a simple proportional allocation policy of common water demand between two parallel reservoirs. Then, the NSGA-II is employed to derive enough noninferior operation rules (design alternatives) in terms of two conflicting objectives (1) minimizing the total deficit ratio (TDR) of all demands of the entire system in operation horizon, and (2) minimizing the maximum deficit ratio (MDR) of water supply in a single period. Next, the SEABODE, a multicriteria decision making (MCDM) procedure, is applied to further eliminate alternatives based on the concept of efficiency of order k with degree p. In SEABODE, the reservoir performance indices and water shortage indices are selected as evaluation criteria for preference ordering among the design alternatives obtained by NSGA-II. The proposed methodology was tested on a regional water supply system with three reservoirs located in the Jialing River, China, where the results demonstrate its applicability and merits.

A question driven socio-hydrological modeling process

Abstract. Human and hydrological systems are coupled: human activity impacts the hydrological cycle and hydrological conditions can, but do not always, trigger changes in human systems. Traditional modeling approaches with no feedback between hydrological and human systems typically cannot offer insight into how different patterns of natural variability or human-induced changes may propagate through this coupled system. Modeling of coupled human–hydrological systems, also called socio-hydrological systems, recognizes the potential for humans to transform hydrological systems and for hydrological conditions to influence human behavior. However, this coupling introduces new challenges and existing literature does not offer clear guidance regarding model conceptualization. There are no universally accepted laws of human behavior as there are for the physical systems; furthermore, a shared understanding of important processes within the field is often used to develop hydrological models, but there is no such consensus on the relevant processes in socio-hydrological systems. Here we present a question driven process to address these challenges. Such an approach allows modeling structure, scope and detail to remain contingent on and adaptive to the question context. We demonstrate the utility of this process by revisiting a classic question in water resources engineering on reservoir operation rules: what is the impact of reservoir operation policy on the reliability of water supply for a growing city? Our example model couples hydrological and human systems by linking the rate of demand decreases to the past reliability to compare standard operating policy (SOP) with hedging policy (HP). The model shows that reservoir storage acts both as a buffer for variability and as a delay triggering oscillations around a sustainable level of demand. HP reduces the threshold for action thereby decreasing the delay and the oscillation effect. As a result, per capita demand decreases during periods of water stress are more frequent but less drastic and the additive effect of small adjustments decreases the tendency of the system to overshoot available supplies. This distinction between the two policies was not apparent using a traditional noncoupled model.

A hedging policy for carriers’ selection under availability and demand uncertainty

We address a stochastic dynamic distribution problem where a family of products needs to be shipped from a warehouse to a distribution center (DC). Uncertainty is on carriers’ availability and demand at the DC. Internal, external and spot carriers must be optimally selected to minimize the expected discounted cost of transportation, inventories and shortages. We numerically prove that an optimal selection policy, SDMBSP, is based on three thresholds of the available inventory in the DC. A simulation model is proposed and proves the robustness of the SDMBSP and its outperformance over two other carrier selection policies.

Transporting Commodities: Hedging Against Price, Demand and Freight Rate Risk with Options

Like options on stocks, options on commodities provide firms with protection against adverse price movements. Many firms procure commodity at an offshore location and transport it via ocean freight. Increased globalization and increased demand for ocean-based transportation has resulted in ocean freight itself becoming a volatile commodity. We consider a commodity processor and develop models to determine the firm’s optimal hedging policy. The models allow for three sources of uncertainty; demand, commodity spot price and freight rate. The scenarios differ based on assumptions on independence between the uncertainties, and also assumptions on market competitiveness. The optimal hedging policies are variants of the classical newsvendor critical fractile. We show that partially procuring the commodity and its freight through option contracts, rather than entirely on the volatile spot market creates value, even for a risk-neutral firm. We then perform extensive numerical experiments to study the influence of the underlying parameters on the optimal hedging policies and value creation.

Firm, market and top management antecedents of speculation: Lessons for corporate governance

In this paper, we explore the corporate governance traits of companies that posted hefty losses related to derivatives trading in the aftermath of the financial crisis. Using concepts from agency theory, cognitive decision making and institutional theory we theorize on potential facilitators of trading losses. Our sample is comprised of 346 companies from 10 international markets, of which 49 companies (and a subsample of 14 distressed companies) lost an aggregate of US$18.9 billion in derivatives. An event study shows that most companies experience substantial and long-term abnormal returns following these incidents. The results of a probit model indicate that the lack of a formal hedging policy, weak monitoring of the top management, overconfidence in technical trends, hubris and remuneration contribute to the mismanagement of hedging policies. Our study contributes to the existing financial risk management literature by identifying antecedents of derivatives losses.

Financial Hedging Decisions on Procurement Risk with Value-at-Risk Consideration

We study how to manage commodity risks (price and volume) via procurement and financial hedging for a value-at-risk (VaR) risk-averse newsvendor. Facing stochastic procurement cost from the commodity market, the firm decides on its financial hedging strategy contingent on the procurement cost with continuous strike prices. After the realization of the procurement cost, the firm determines the order quantity under demand uncertainty. We derive closed-form solution of the joint optimal order quantity and financial hedging policy, which is proved to be time-consistent and risk-coherent. Furthermore, we show how financial hedging turns risks into rewards by rebalancing the payoffs under different spot price realizations, thus characterizing the value of financial hedging. We investigate the effects of these two parameters of VaR, i.e., the tolerance level divides the decision region into two that tends toward over-spending or short-spending, respectively. The profit reservation level lowers the risk-neutral order quantity in the over-spending region but raises it in the short-spending region. Numerical studies show that procurement cost uncertainty may improve the expected profit due to our comprehensive hedging policy and postponed order decision. The interaction between the operational and financial decision presents more value in the scenarios where there are a volatile demand and a negative correlation between demand and procurement cost.

On macrohedging problem in semimartingale markets

Macrohedging is a hedging technique commonly used in practice. It allows one to find a hedging policy that offsets several underlying risk factors of a portfolio of assets as a whole. Here, we develop a macrohedging methodology in a general semimartingale market. We calculate the optimal macrohedge that achieves minimum risk, in a quadratic-variation sense, given a set of possible hedging instruments. We illustrate general macrohedging results by the Black-Scholes model.

Reply to the “Discussion by Irene Garousi-Nejad, Omid Bozorg Haddad, and Mahyar Aboutalebi on ‘Investigating parameters of two-point hedging policy for operating a storage reservoir’, by Sharad K. Jain (2015)”

Reply to the “Discussion by Irene Garousi-Nejad, Omid Bozorg Haddad, and Mahyar Aboutalebi on ‘Investigating parameters of two-point hedging policy for operating a storage reservoir’, by Sharad K. Jain (2015)”

Hedging Commodity Procurement in a Bilateral Supply Chain

This paper explores the merits of hedging stochastic input costs (i.e., reducing the risk of adverse changes in costs) in a decentralized, risk-neutral supply chain. Specifically, we consider a generalized version of the well-known “selling-to-the-newsvendor” model in which both the upstream and the downstream firms face stochastic input costs. The firms’ operations are intertwined—i.e., the downstream buyer depends on the upstream supplier for delivery and the supplier depends on the buyer for purchase. We show that if left unmanaged, the stochastic costs that reverberate through the supply chain can lead to significant financial losses. The situation could deteriorate to the point of a supply disruption if at least one of the supply chain members cannot profitably make its product. To the extent that hedging can ensure continuation in supply, hedging can have value to at least some of the members of the supply chain. We identify conditions under which the risk of the supply chain breakdown will cause the supply chain members to hedge their input costs: (i) the downstream buyer’s market power exceeds a critical threshold; or (ii) the upstream firm operates on a large margin, there is a high baseline demand for downstream firm’s final product, and the downstream firm’s market power is below a critical threshold. In absence of these conditions there are equilibria in which neither firm hedges. To sustain hedging in equilibrium, both firms must hedge and supply chain breakdown must be costly. The equilibrium hedging policy will (in general) be a partial hedging policy. There are also situations when firms hedge in equilibrium although hedging reduces their expected payoff.

Some covariance inequalities for non-monotonic functions with applications to mean-variance indifference curves and bank hedging

In several problems of decision-making under uncertainty, it is necessary to study the sign of the covariance between marginal utilities. All of the works that study the covariance signs are based on Chebyschev’s integral inequality. However, this inequality requires that both functions be monotonic. There are many cases, originated basically by new alternative theories, which assume that the marginal utilities of interest are non-monotonic. Thus, we cannot use Chebyschev’s result as it relies on monotonic functions. In this article, I derive some new covariance inequalities for utility functions which have non-monotonic marginal utilities. I also apply the theoretical results to two problems in economics: First, I study some properties of the indiference curve in the mean-variance space for Prospect Theory and for Markowitz utility functions. Second, I analyze the asset hedging policies of a bank that behaves as predicted by Prospect Theory.

Genetic algorithms optimization of hedging rules for operation of the multi-purpose Ubonratana Reservoir in Thailand

Abstract. This study has developed optimal hedging policies for the multi-purpose Ubonratana Reservoir in northeastern Thailand based on its existing rule curves. The hedging policy was applied whenever the reservoir storage falls below a critical level for each month of the year. The decision variables, i.e. the set of monthly storages defining the critical rule curve that triggers rationing and the rationing ratio, were optimized by genetic algorithm (GA). Both single stage (i.e. with one critical rule curve and one rationing ratio) and two-stage (with two critical rule curves and ratios) of the hedging policy were considered in the optimization. To test the effect of the optimized hedging policies on reservoir performance, simulations were carried out, forced alternatively with the existing rule curves (i.e. without hedging) and the two optimized hedging policies. Performance was summarized in terms of reliability (time- and volume-based) and vulnerability. The results showed that the vulnerability was significantly reduced by using the optimized hedging rules. However, the number of water shortages increased with the optimized rules, causing the time-based reliability to worsen significantly. This should not be of concern since, although the number of shortages increased, the associated shortage quantities on most of these additional occasions were small, leaving the volumetric reliability largely unchanged.

KEBIJAKAN HEDGING DENGAN DERIVATIF VALUTA ASING PADA PERUSAHAAN GO PUBLIC DI INDONESIA PERIODE 2009-2012

This study aims to test the Hedging Policy with Foreign Currency Derivatives Companies Go Public In the period 2009-2012 in Indonesia have hedging dependent variable, and independent variables consist of DER, ICR, MBV, LnTA and CR. The method in this study using a tool such as Regression Logit (Binary Logit) were further tested by assessing the feasibility of the regression model (Goodness of fit test) and a value R2 Karke Nagel. Testing the hypothesis in this research using multiple ways of testing, ie Simultaneous testing using Omnibus Test of Model Coefficients. Partial and testing employ the Wald statistical test method of logistic regression results. The result of the logit regression is used to determine how far influence the policy of hedging the company went public in Indonesia. The results of this study indicate that the independent variables consist of DER, ICR, MBV, LnTA and CR simultaneously affect hedging policy at the company went public in Indonesia. Partially ICR affect the hedging policy of the company went public in Indonesia, while DER, MBV, LnTA and CR had no effect on the hedging policy of the company went public in Indonesia.

Exposure, hedging, and value: New evidence from the U.S. airline industry

For a variety of reasons, the U.S. airline industry is a natural sample to analyze the relation between corporate risk exposure, hedging policy, and firm value. First, we find that airline exposures to fuel prices are higher when fuel prices are high or when they are rising. Second, we analyze the relation between exposure coefficients and the percentage of next year's fuel requirement hedged by airlines. In response to higher fuel price levels, rising fuel prices, and higher levels of exposure to fuel prices, airlines tend to increase their hedging activity. Finally, we explore the previously documented jet fuel hedging premium illustrated in Carter, Rogers, and Simkins (2006). We find a positive hedging premium in our analysis; however, the interaction of hedging and exposure does not affect firm value. We conclude that airlines increasing hedging activity because of higher fuel price exposure are not valued higher compared to those airlines employing more stable hedging policies.

Currency Hedging Policy

Based on recently available evidence, a fairly broad consensus on hedging policy appears to be emerging. We have included a copy and commentaries on four key currency hedging policy articles. Also included is a critique on Black's Universal Hedging Formula and a paper on short-term investing. The focus of this discussion is on defining an appropriate currency hedging policy, and not on the benefits of actively managing currencies. These two decisions are independent. Hedging policy defines the desired benchmark for a passive currency management program as well as for measuring active currency management performance, much as equity market indexes are typically utilized as benchmarks.

Local institutional shareholders and corporate hedging policies

This paper examines the effectiveness of monitoring function from institutional investors on corporate hedging strategy in Taiwan over the period from 2005 to 2012. The empirical results show that institutional investors are effective monitors of corporate risk management to enhance the probability and extent of hedging. In addition, the monitoring function from institutional investors is effective for mitigating the risk-shifting problem of high leveraged firms. Moreover, local institutional investors play more important role in monitoring distressed firm's magnitude of hedging than foreign institutional investors. These results are robust to the consideration of endogeneity, selection bias, and industrial difference. This is the first empirical evidence in the literature regarding the monitoring effect of institutional investors on risk management strategy from the angle of monitoring costs.

Time-consistent mean–variance hedging of longevity risk: Effect of cointegration

This paper investigates the time-consistent dynamic mean–variance hedging of longevity risk with a longevity security contingent on a mortality index or the national mortality. Using an HJB framework, we solve the hedging problem in which insurance liabilities follow a doubly stochastic Poisson process with an intensity rate that is correlated and cointegrated to the index mortality rate. The derived closed-form optimal hedging policy articulates the important role of cointegration in longevity hedging. We show numerically that a time-consistent hedging policy is a smoother function in time when compared with its time-inconsistent counterpart.

Efficient versus inefficient hedging strategies in the presence of financial and longevity (value at) risk

This paper provides a closed-form Value-at-Risk (VaR) for the net exposure of an annuity provider, taking into account both mortality and interest-rate risk, on both assets and liabilities. It builds a classical risk-return frontier and shows that hedging strategies–such as the transfer of longevity risk–may increase the overall risk while decreasing expected returns, thus resulting in inefficient outcomes. Once calibrated to the 2010 UK longevity and bond market, the model gives conditions under which hedging policies become inefficient.

Investigating parameters of two-point hedging policy for operating a storage reservoir

In the operation of a reservoir, at times it is rational not to meet the current demands in full even though there may be enough water to do so. The idea is to save some water to avoid large future shortages. Hedging policies are implemented to achieve this objective. Draper and Lund (2004) found that where hedging is desirable, a linear “two-point” hedging policy may be near optimal for a wide range of circumstances. This paper has examined the behaviour of two parameters of two-point hedging. It appears that in most situations, parameter A which determines when hedging should be triggered is likely to fall between 0.2 and 0.8. For parameter B which controls when hedging should be stopped is likely to be in the range 1.4–1.6. It was also found that the trigger point for commencement of hedging steadily falls as the correlation between demands and reservoir inflows decreases. Results of this study would help in applying simulation models to determine optimum values of the parameters of two-point hedging policy by narrowing the search region.

Do Family Owners Use Firm Hedging Policy to Hedge Personal Undiversified Wealth Risk?

We examine whether family ownership affects the value impact of the operational and financial dimensions of firms’ hedging policies. We show that family firms’ market valuations are higher than those of non‐family firms, consistent with the view that family firms benefit from family owners’ long‐term perspectives and ability to monitor managers. In addition, while both operational and financial hedging policies per se are valuable in non‐family firms, they do not create any value in family firms. These results support the notion that the founding families’ need to hedge the risk of their undiversified personal wealth portfolio leads to suboptimal risk management decisions.